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Collections of Value Investing articles, interviews and videos, especially on Warren Buffett and Charlie Munger and articles from various disciplines to build "Latticework of Mental Models"

Wednesday, December 19, 2007

Mark Sellers: Rational investors should rejoice

Two months ago in my Financial Times column, I listed some of the things I have learnt about the stock market over the years. I likened the market to a game of online poker, with anonymous opponents and continuously evolving probabilities. I received some good reader feedback, so this month I’ve decided to revisit the topic. Here are a few more things I’ve learnt about the stock market.

1. People can’t handle high returns.

People say they want to make a lot of money in the stock market but, because of human psychology, very few can handle the volatility that comes with this pursuit. The pain of losing $1, even temporarily, is much greater than the pleasure of making $1.

The book Fortunes Formula details the origins of a formula developed by Bell Labs mathematician John Kelly. His formula allows a gambler to determine the optimal bet size if the gambler can estimate the odds of winning the bet and the pay-off for winning compared with the penalty for losing. The formula can also be modified so that it applies to multiple simultaneous bets – in other words, a stock portfolio.

By studying the Kelly formula, as I have, it becomes apparent that in order to get optimal portfolio returns, an investor has to be willing to endure a lot of volatility. That is because the Kelly formula will have you making large, concentrated bets when you find favourable risk/reward opportunities. And concentration brings volatility.

This is unacceptable to most people because they irrationally equate short-term volatility with risk. So rather than achieving optimal portfolio returns coupled with high volatility, people would rather achieve sub-optimal portfolio returns coupled with low volatility. And that’s why few funds stand out from the crowd; they’re giving their customers what they want.